Equity is more expensive than debt because shareholders accept risks that lenders do not, and the tax code rewards borrowing while punishing dividend payouts. A lender has a contract, a repayment date, and a senior claim in bankruptcy. A shareholder has none of that, and the company gets no tax deduction for paying them. Add dilution and higher issuance costs, and the spread between the two forms of capital is structural, not incidental.
Lenders Have a Contract; Shareholders Do Not
A loan is a promise. The borrower owes a fixed interest rate and must return the principal on a set date, no matter how the business performed that year. Miss a payment, and the lender can seize collateral, force restructuring, or push the company into bankruptcy. That certainty is what makes a lender’s position predictable and, therefore, cheaper to fill.
Shareholders get no equivalent promise. A board can pay dividends or hoard every dollar of profit, and no individual investor can force a payout. If the stock falls 90%, the shareholder eats the loss. To take that open-ended position, equity investors demand a higher expected return. They need the upside to be large enough to justify the real chance of walking away with nothing.
Shareholders Stand Last in Bankruptcy
Bankruptcy law hardens the risk gap into rank order. Under the absolute priority rule in 11 U.S.C. § 1129, a reorganization plan can only be confirmed if it respects a strict hierarchy: secured creditors first, unsecured creditors next, equity holders last.1Office of the Law Revision Counsel. 11 USC 1129 – Confirmation of Plan Shareholders receive nothing until every class above them has been paid in full or has agreed to accept less.
Most corporate liquidations run out of assets long before the equity holders’ turn. Bondholders and banks recover part of what they are owed; common stockholders typically recover zero. That back-of-the-line position is the single biggest reason equity has to promise more in good times. The worst seat at the table only gets filled if the meal is priced accordingly.
The Tax Code Subsidizes Debt and Taxes Dividends Twice
Under 26 U.S.C. § 163(a), a business can deduct interest paid on its debts from gross income.2Office of the Law Revision Counsel. 26 USC 163 – Interest With the federal corporate rate at 21%, a 7% loan actually costs the company about 5.5% after tax (7% × 0.79). The Treasury absorbs roughly a fifth of the interest bill.
Dividends work the other direction. A corporation pays them out of after-tax profits, so the money has already been taxed once at the entity level. When the shareholder receives the dividend, it counts as taxable income again under 26 U.S.C. § 301.3Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property Double taxation means the company gets no tax break for compensating its equity investors, and the investor keeps less of every dollar received. That widens the effective spread between debt and equity well past what headline rates and expected returns suggest on their own.
Limits on the Interest Deduction
The tax shield is real but capped. Section 163(j) limits deductible business interest in any year to 30% of adjusted taxable income, plus any business interest income the company earned. Since 2022, adjusted taxable income no longer adds back depreciation and amortization, so capital-intensive businesses see a smaller deductible amount. Interest above the cap carries forward, but the delay eats into its present value. Small companies with average annual gross receipts under an inflation-adjusted threshold ($29 million for 2023) escape the cap entirely.4Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Companies that try to disguise equity as debt to grab the deduction face reclassification. Under 26 U.S.C. § 385, the Treasury can prescribe factors for deciding whether an instrument is really stock rather than a loan, including whether there is a fixed repayment date, the company’s debt-to-equity ratio, conversion features, and the relationship between the lender and the shareholders.5Office of the Law Revision Counsel. 26 USC 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness If the IRS calls it equity, the interest deduction disappears.
Issuing Equity Dilutes Existing Owners
Selling new shares costs current shareholders something a loan never does: ownership. When a company creates and sells additional stock, every existing shareholder’s percentage shrinks. A 1% owner of a company with 100 million shares outstanding drops to about 0.83% if 20 million new shares are issued. That smaller slice means less claim on future earnings, smaller dividend checks, and less voting weight.
Dilution stings most when shares are sold below their intrinsic value, because current owners effectively subsidize the newcomers. Even when the fresh capital funds real growth, management has to clear a higher bar: the value created must exceed the ownership erosion. Debt raises liabilities on the balance sheet but leaves the ownership pie intact. That is one reason many companies borrow up to a comfortable limit before turning to equity.
Issuance Costs Are Higher for Equity
Selling shares is also more expensive to execute than taking out a loan. A public equity offering carries SEC registration fees (currently $153.10 per million dollars of securities registered), underwriting spreads that commonly run 3% to 7% of the raise, and layered legal and accounting costs.6U.S. Securities and Exchange Commission. Section 6(b) Filing Fee Rate Advisory for Fiscal Year 2025 Private placements skip full registration but still require a Form D filing with the SEC within 15 days of the first sale.7U.S. Securities and Exchange Commission. Filing a Form D Notice Arranging a bank loan typically involves an origination fee of 1% to 2% and far less legal overhead. Those upfront costs get folded into the all-in cost of capital, pushing equity’s price up further.
What the Numbers Look Like
The capital asset pricing model puts a figure on the spread. It adds a risk-free rate (usually the yield on long-term Treasuries) to the product of the company’s beta and the equity risk premium. As of January 2026, Aswath Damodaran’s widely used estimate places the U.S. equity risk premium at 4.46%.8NYU Stern – Damodaran Online. Country Default Spreads and Risk Premiums Layer that on a risk-free rate near 4.5% and a beta of 1.0, and the cost of equity for an average U.S. company lands near 9%. Investment-grade corporate bonds yield in the 5% to 5.5% range, which translates to an after-tax cost of roughly 4% to 4.3% at a 21% tax rate.
A volatile growth company with a beta well above 1.0 faces a steeper equity cost. A stable utility with a low beta narrows the gap. The gap never closes, though. It reflects compensation for uncertain cash flows, liquidation risk, the missing tax deduction, and dilution. Debt has its own drawbacks for the borrower, including covenants that can restrict new borrowing, acquisitions, dividends, and asset sales. Those constraints are real, but they show up as operational friction rather than a higher financial cost of capital.
The practical upshot for a balance sheet: cheap debt amplifies shareholder returns when a business is doing well, and amplifies losses when it is not. Push the leverage too far and the company runs into the 163(j) cap, tighter covenants, and lenders who start pricing in default risk of their own. The lowest overall cost of capital usually sits at a moderate debt-to-equity ratio, where the tax shield is doing meaningful work and the company is not yet leveraged past the point where its debt starts to behave, in cost terms, like equity.